I don’t know about you, but I’d rather have all my investments be tax-free. While this may not be possible, it pays to understand our options when it comes to building tax-free wealth.
401(k)s came into existence in the late 70s and were widely adopted in the early 80s. In 1981, the highest marginal tax rate was 69.13%. Savers were excited to be able to make pre-tax contributions to their 401(k)s because it allowed them to reduce their tax liability.
The thinking was, when I’m in my highest income earning years, I want to defer as much as I can. When I retire, I’ll be making less money, so I’ll be able to drop down several tax brackets.
Today, there are fewer tax brackets, and the highest marginal tax rate in 2022 was 37% If you were deferring in 1981, and taking money out in 2022, your strategy worked perfectly. You deferred in a high income tax environment, and withdrew in a lower tax rate environment.
What about today?
Since we don’t know what the future holds, we can’t fully answer that question. But what if taxes are higher in the future? If that turns out to be the case, it wouldn’t make sense to defer paying taxes in a lower tax bracket, and then withdraw and have to pay taxes at a higher tax rate.
In the interest of helping you understand your options in buidling tax-free wealth, here are the six options I’ll cover:
- Roth IRAs
- Roth 401(k)s
- Municipal bonds
- 529 plans
- Life insurance
- Roth conversions
Let’s get started.
Roth IRAs
Roth IRAs are the opposite of Traditional IRAs from a tax perspective. You make contributions with after-tax dollars, meaning the government has already gotten to tax your income.
Once inside the account, your money grows tax-deferred, meaning it is not being taxed as it’s growing. When you’re ready to withdraw from the account, everything comes out tax-free.
Roth’s also differ from Traditional IRAs in that after the account has been open for at least five years, you can withdraw money without penalty.
A good way to think about Roth versus Traditional is this; a farmer is getting ready to plant her fields for the season. She goes to the general store to buy seeds and she runs into the tax collector. Tax collector says, “Either I can give you the seeds for free today and tax your entire harvest, or I can tax the seeds today and you can get your entire harvest for free.” Farmer scratches her head and says, “I’ll pay the tax on the seeds.”
There are limits on how much you can contribute to Roth IRAs every year. There are also “phase outs,” meaning you may be unable to make a Roth contribution if you’re making too much money.
Roth 401(k)s
This option within 401(k) plans operates the same way as a Roth IRA. The benefits are these; there are no “phase outs,” and you can contribute a greater amount than you can to an IRA.
Municipal bonds
Commonly known as “tax-free” municipal bonds, these are debt instruments issued by state and local governments to raise capital for projects. These projects range from infrastructure, to schools, to funding day-to-day expenses.
One of the key benefits of a municipal bond is that it’s free from federal income tax. They can also be free from state income tax should you live in the state where the bond is issued.
You can purchase the bond itself from a bank or financial firm. They are also available through ETFs (exchange traded funds).
Do these make sense in your portfolio? You’ll need to research and determine the interest rate you’ll receive from the bond, and then factor in the tax benefits you’ll receive. Based on that information, you’ll be able to make a determination.
529 plans
These are accounts that are used to save for education related expenses. Allowable expenses have been expanded to include K through college tuition, student loan repayment, and other education related expenses.
These plans offer tax-deferred growth and tax-free withdrawals when used for the qualified expenses mentioned above. You may also be able to deduct your contributions if you’re a resident of the state the plan is based in.
A potential drawback of these plans exists should you not need the funds for education related expenses. Should you simply withdraw the money, you’ll pay a 10% on any gains.
All in all, these are wonderful accounts should you have educational expenses.
Life insurance
Fundamentally, there are two types of life insurance; term and permanent. Term insurance has no cash value. Permanent insurance can have a cash value, depending on the product. Certain types of permanent, cash value life insurance policies have tax benefits.
As you make your premium payments, there is a tax levied on them. After taxes, cost of insurance, and other fees and expenses are withdrawn from the premium, what’s left over goes into the policy’s cash value. This cash value grows on a tax-deferred basis.
You may be able to access the cash value, and when you do, you can do so tax-free. There are several terms for this strategy including Infinite Banking and Private Banking.
The success of these strategies depends on the individual policy and the way it’s structured. Life insurance policies vary widely from company to company, and they are complex financial products.
This may be a viable option for you, but please be sure to work with a professional who has experience in the field.
If you’d like to connect with one of our Certified Partners, you can do so here.
Roth conversions
If you have an existing Traditional IRA, you have the option of converting it to a Roth IRA. You may consider doing this if you’d like your retirement assets to be tax-free.
The process works similarly to other IRA transfers or rollovers. You’ll establish a Roth IRA, and move the money from Traditional to your Roth account.
Here’s the rub; you’ll owe ordinary income tax on all the money you move in the year you do it. So, if you had a Traditional IRA with $100,000 and you converted it a Roth IRA, you would have $100,000 added to your earned income for that year.
If you’d like to connect with one of our Certified Partners, you can do so here.
Bonus: Taxes
When it comes to taxes, I want to remind or make you aware of the important distinction between short and long-term capital gains. Simply put, if you own an asset for less than one year and sell it, you’ll pay a short-term capital gain on your profits.
If you hold the same asset for one year or more, you’ll pay a long-term capital gain. Historically, the percentage is higher for short-term versus long-term capital gains. Therefore, if you’re able to wait until you’ve owned the asset for at least one year, you’ll be better off from a tax perspective.
While taxes should not be the main influence behind when you sell an asset, it pays to be mindful of them.
Resources
You can access our Goals and Values courses at no-cost.
If you’re ready to become the CEO of your financial life, check out our DIY Financial Plan workshop.
If you’d like to connect with one of our Certified Partners, you can do so here.
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